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Purpose – This paper aims to estimate a New Keynesian small open economy dynamic stochastic general equilibrium (DSGE) model for Egypt using Bayesian techniques and data for the period FY2004/2005:Q1- FY2015/2016:Q4 to assess monetary and ﬁscal policy interactions and their impact on economic stabilization. Outcomes of monetary and ﬁscal authority commitment to policy instruments, interest rate, government spending and taxes, are evaluated using Taylor-type and optimal simple rules. Design/methodology/approach – The study extends the stylized micro-founded small open economy New Keynesian DSGE model, proposed by Lubik and Schorfheide (2007), by explicitly introducing ﬁscal policy behavior into the model (Fragetta and Kirsanova, 2010 and Çebi, 2011). The model is calibrated using quarterly data for Egypt on key macroeconomic variables during FY2004/2005:Q1-FY2015/2016:Q4; and Bayesian methods are used in estimation. Findings – The results show that monetary and ﬁscal policy instruments in Egypt contribute to economic stability through their effects on inﬂation, output and debt stock. The monetary policy Taylor rule estimates reveal that the Central Bank of Egypt (CBE) attaches signiﬁcant importance to anti-inﬂationary policy and (to a lesser extent) to output targeting but responds weakly to nominal exchange rate variations. CBE decisions are signiﬁcantly inﬂuenced by interest rate smoothing. Egyptian ﬁscal policy has an important role in output and government debt stabilization. Additionally, the ﬁscal authority chooses pro-cyclical government spending and counter-cyclical tax policies for output stabilization. Again, past values of the ﬁscal instruments are inﬂuential in the evolution of the future ﬁscal policy-making process. Originality/value – A few studies have examined the interaction between monetary and ﬁscal policy in Egypt within a uniﬁed framework. The presented paper integrates the monetary and ﬁscal policy analysis within a uniﬁed dynamic general equilibrium open economy rational expectations framework. Without such a framework, it would not be easy to jointly analyze monetary and ﬁscal transmission mechanisms for output, inﬂation and debt. Also, it would be neither possible to contrast the outcome of monetary and ﬁscal authorities commitment to a simple Taylor instrument rule vis-à-vis optimal policy outcomes nor to assess the behavior of monetary and ﬁscal agents in macroeconomic stability in context of an active/passive policy decisions framework. Keywords DSGE, Economic stabilization, Monetary and ﬁscal policy, Optimal rules Paper type Research paper © Sherine Al-shawarby and Mai El Mossallamy. Published in Review of Economics and Political Science. Published by Emerald Publishing Limited. This article is published under the Creative Commons Attribution (CC BY 4.0) licence. Anyone may reproduce, distribute, translate and create Review of Economics and Political Science derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The full terms of this licence may be seen at http:// pp. 138-157 Emerald Publishing Limited creativecommons.org/licences/by/4.0/legalcode 2631-3561 DOI 10.1108/REPS-03-2019-0033 JEL classiﬁcation – E52, E61, E62, E63 1. Introduction Optimal rules The Egyptian Government launched a comprehensive reform program in 2014 to rebuild conﬁdence in the economy after two consecutive uprisings in 2011 and 2013. The goal of the program was to strengthen macroeconomic performance by introducing a set of monetary and ﬁscal policy reform measures (World Bank, 2015). Monetary reform included the Central Bank of Egypt’s (CBE’s) decision to liberalize the Egyptian pound in November 2016. The primary goal of the ﬁscal reform program was to trim the budget deﬁcit and improve the structure of government spending without jeopardizing economic growth [GOE (Government of Egypt), 2015]. Coordination between macroeconomic policies is essential for achieving the objectives of the program. Recently, examining the monetary and ﬁscal policy mix has become important in view of government attempts to stimulate growth, control inﬂation, overcome ﬁscal budget problems and maintain the drive toward more CBE independence. Hence, the main objective of this paper is to study the dynamic interactions between monetary and ﬁscal policies in Egypt during the period 2004/05-2015/16, assess their contribution to macroeconomic performance and craft insights of an integrated optimal policy framework for inciting economic stability. A few studies have examined the interaction between monetary and ﬁscal policy in Egypt within a uniﬁed framework (Panizza, 2001; Hassan et al.,2014 and Abdel-Haleim, 2016). None of these studies, however, has integrated the analysis within a uniﬁed dynamic general equilibrium open economy rational expectations framework. Without such a framework, it would not be easy to jointly analyze monetary and ﬁscal transmission mechanisms for output, inﬂation and debt. Neither would it be possible to contrast the outcome of CBE and ﬁscal authority commitment to a simple Taylor instrument rule vis-à- vis optimal policy outcomes; nor to assess the behavior of monetary and ﬁscal agents on macroeconomic stability in context of an active/passive policy decisions framework[1]. To overcome these limitations, the present study extends the stylized micro-founded small open economy New Keynesian dynamic stochastic general equilibrium (DSGE) model, proposed by Lubik and Schorfheide (2007), by explicitly introducing ﬁscal policy behavior into the model (Fragetta and Kirsanova, 2010 and Çebi, 2011). The model is calibrated using quarterly data for Egypt on key macroeconomic variables during FY2004/2005:Q1-FY2015/ 2016:Q4, and Bayesian methods are used in estimation. The estimates of the simple Taylor rule and optimal simple rule (OSR) generally indicate that CBE pursues an anti-inﬂationary policy. Recent success of the CBE in achieving its inﬂation target has positively contributed to macroeconomic stability despite accumulated government debt and growing budget deﬁcit[2]. In particular, the Taylor rule reaction function estimates reveal that the CBE attaches signiﬁcant importance to inﬂation and output targeting while responding weakly to nominal exchange rate variations. Besides, CBE tends to adopt a counter-cyclical policy as an instrument for monetary stabilization. The analysis reveals that monetary policy decisions reﬂect a signiﬁcant degree of interest rate smoothing, which may render CBE policy responses overtly transparent and anticipated. A large smoothing coefﬁcient suggests that – ceteris paribus – the monetary authority adjusts its policy instrument gradually from period to period. Generally, central banks tend to smooth changes in interest rates owing to uncertainty about the economy, which may lead the monetary authority to respond cautiously until the economic situation became clearer and less uncertain. Another justiﬁcation is the fear of instability in the ﬁnancial market that may induce considerable changes especially for countries suffering from large debts. Interest rate smoothing can also be related to the transparency and credibility of the central bank. Central bankers may choose to adopt small and persistent changes in interest rate over an extended period of time REPS rather than large and transitory changes to realize higher economic stability (Clarida et al., 4,2 2000 and Srour, 2001). On the ﬁscal front, the results suggest a sizable level of policy inertia, indicating that past values of the ﬁscal instruments (government spending and taxes) are inﬂuential in the future evolution of the ﬁscal policy making process in Egypt. The results further disclose that while ﬁscal policy involving government spending is pro-cyclical, it is counter-cyclical when implemented through income taxes. The analysis demonstrates that ﬁscal policy plays an important role in government debt and output stabilization, especially when income taxes are used as a policy instrument. The behavior of the ﬁscal authority toward debt stabilization suggests that the Egyptian Government adopts a Leeper (1991) passive ﬁscal policy. According to Leeper (1991), active/passive policy is deﬁned according to policy responsiveness to a shock in public debt. Characterizing the behavior of monetary/ﬁscal authority as active or passive depends on the constraints and restrictions that the speciﬁc authority faces. An active authority, primarily, focuses on realizing its targets without regard neither to the budget deﬁcit position nor the behavior of current and past variables controlled by the passive authority. Alternatively, the passive authority opts to generate sufﬁcient revenues to balance the budget deﬁcit based on a decision rule that is a function of the current position of public debt. Alternatively, the OSR results recommend moderate response to inﬂation compared with analogous Taylor rule estimates. They also suggest that the monetary authority targets exchange rate variations. The OSR estimates disclose virtually muted response to output. Hence, the monetary authority would not want to account for output ﬂuctuations when optimally setting its operational target. The optimization results recommend that government should heavily target debt stabilization. In that case, the ﬁscal agent would adhere to a passive policy in the Leeper sense. When there is a rise in ﬁscal debt, adopting a Leeper passive monetary stance would support the consolidation of the ﬁscal balance, though probably accompanied with higher inﬂationary pressure. However, if the CBE adopts an active policy, then the ﬁscal debt stabilization policy may be restrained by monetary policy. Additionally, the OSR ﬁndings reveal that the ﬁscal authority should moderately target output stabilization and underscore the merits of pro-cyclical government spending in Egypt (i.e. higher expenditures during a boom and lower in periods of recession). Such pro-cyclicality may be interpreted in context of the structure of the Egyptian Government budget. The substantial share of ﬁxed expenses in total expenditure is likely to limit the government ability to implement an independent ﬁscal policy, as those expenditures represent outcomes of earlier decisions that are not easily adjustable in the short-run without triggering economic imbalances (Gavin et al.,1996). Moreover, the OSR ﬁndings are inclined towards a counter-cyclical income tax policy. Because tax revenues are under ﬁscal authority control, the government has the ﬂexibility to counter-cyclically interfere by raising (cutting) taxes during booms (recessions) to restore stability and reduce adverse effects on the ﬁscal budget, especially during economic downturns. Finally, the ﬁndings reveal that the smoothing coefﬁcients derived from Taylor instrument rules are more gradual and persistent in comparison with analogous estimates from the OSR scenarios, suggesting that the OSR advocates immediate sizeable responses to shocks rather in contrast with slower and weaker Taylor-type responses, which may help monetary/ﬁscal authorities to quickly achieve policy targets (Srour, 2001). The rest of the paper is organized as follows. Section 2 presents an overview of the Egyptian economy. Section 3 outlines the basic structure of the DSGE model for Egypt. Section 4 describes the data and choice of priors and presents the Bayesian estimates of the Optimal rules model. Section 5 analyzes optimal monetary and ﬁscal policy implications based on the OSR model. Section 6 concludes. The model equations are portrayed in the Appendix. 2. Overview of Egyptian macroeconomic performance Since the mid-2000s, the Egyptian economy has faced repercussions of socioeconomic and political changes that took place on both the international and domestic sides. The global ﬁnancial and world food prices crises disrupted the Egyptian economy in the second half of 2008 leading to a slowdown in economic activity and a decline in the relatively high rates of economic growth that prevailed in previous years. Moreover, social and economic disturbances owing to the two consecutive uprisings in 2011 and 2013 adversely affected the performance of the economy. The average annual growth rate averaged approximately 6.4 per cent during 2005-2008 reaching 7.2 per cent by the end of the period. In 2009, real GDP growth started to decline reaching a record low of 1.8 per cent in the aftermath of the 2011 revolution. Foreign reserves fell about 50 per cent within the period December 2010-December 2011, reaching US $15.5bn in 2012 (allowing only for a borderline three months imports cover). The average annualized CPI inﬂation was about 10 per cent during 2005-2008, reaching a peak of 23 per cent in August 2008 owing to the global ﬁnancial crisis. The annualized inﬂation rate stabilized around 9.7 per cent from 2011 until the devaluation of the Egyptian pound in November 2016. Besides, the government debt to GDP ratio averaged 83.4 per cent during 2008-2017, ﬂuctuating between a record low of 73.3 per cent in 2009 and an all-time high of 101.2 per cent in 2017. To promote economic activity and control the budget debt, the Egyptian Government launched a comprehensive reform program in 2014. The program aimed to strengthen macroeconomic performance by stimulating output growth, promoting price and debt stabilization and improving the business and investment climate (World Bank, 2015). The reform program involved a set of monetary and ﬁscal reform measures. The monetary measures essentially included the CBE decision to liberalize the Egyptian pound in November 2016. The move toward a ﬂoating exchange rate regime signiﬁcantly contributed to the elimination of distortions in the domestic-foreign currency market and put an end to the parallel exchange rate system. It has also helped in accumulating foreign currency reserves. The primary goal of the ﬁscal reform program was to reduce government debt, trim the budget deﬁcit and improve the structure of government spending without jeopardizing economic growth [GOE (Government of Egypt), 2015]. On the revenue side, the ﬁscal policy reform measures included adjustment of the tax system, e.g. introducing a value added tax. Alternatively, on the expenditure side, the government’s ﬁscal consolidation program aimed at restraining the growth of government wages and compensation bill through selected policy intervention measures. The ﬁscal authority has started incremental reductions in energy subsidies by applying fuel and electricity pricing reforms, thereby allowing the government to redirect expenditures towards priority areas such as education, health, infrastructure and social protection programs [GOE (Government of Egypt), 2015; World Bank, 2015 and Ministry of Finance (MOF), 2016]. The economic reform program has attempted to strengthen macroeconomic performance by playing an important role in, gradually, restoring trust in the Egyptian economy. The initial signs of economic improvement and recovery are marked by developments in key economic indicators. The annual GDP growth reached 4.2 per cent in 2016/2017 (surpassing the IMF forecast of 3.5 per cent). The ﬁrst quarter of the current ﬁscal year 2017/2018 has registered a 5.2 per cent growth in real GDP compared to its analogue (3.4 per cent) in 2016/ REPS 2017. The unemployment rate witnessed a gradual decrease during the ﬁscal year 2016/ 4,2 2017, reaching 11.9 per cent in 2016/2017:Q3, in contrast to 12.6 per cent during the same quarter in the previous year. Alternatively, in the aftermath of the recent ﬂoatation of the Egyptian pound, the value of the Egyptian currency registered an unprecedented decrease with the exchange rate hovering above EGP 18 per 1 USD by the end of March 2017 in comparison with EGP 8.78 just eight months earlier [CBE (Central Bank of Egypt), 2016/ 2017]. Pass-through effects associated with the devaluation of the Pound contributed to the signiﬁcant increase in the annual CPI inﬂation, which reached a peak at 34.2 per cent in July 2017 versus 14.8 per cent in the previous year [Ministry of Finance (MOF), 2017]. On the upside, exchange market reforms resulted in a net increase in international reserves that rose considerably by more than 185 per cent from a low of US$13.4bn in March 2016 to US$38.2bn in January 2018, equivalent to 8.2 months of imports cover. In addition, to curb high inﬂation, the CBE has implemented successive increases in the overnight interbank rate. The annual inﬂation started to decline gradually reaching 13.6 per cent by August 2018. Concurrent implementation of monetary and ﬁscal policy adjustments necessitates appropriate interaction between those policies to motivate stable output growth, manageable budget deﬁcit and acceptable levels of inﬂation in Egypt. Accordingly, coordination between macroeconomic policies is essential for achieving the objectives of the reform program. 3. A dynamic stochastic general equilibrium model for Egypt with monetary and ﬁscal policies This study extends the stylized small open economy DSGE model by Lubik and Schorfheide (2007) – based on the seminal work of Galí and Monacelli (2005) – by formally introducing ﬁscal policy behavior within the modeling structure (Fragetta and Kirsanova, 2010 and Çebi, 2011). Hence, it would be possible to analyze policy interactions and simultaneously evaluate the role of ﬁscal and monetary strategies in stabilizing the Egyptian economy. The DSGE construct speciﬁes a linear rational expectation model that consists of four main types of economic agents: households, ﬁrms, central bank and government. The micro- foundations for the model are based on households that maximize an intertemporal utility function subject to a budget constraint. Monopolistically competitive proﬁt maximizing ﬁrms produce differentiated goods and determine prices, within a New Keynesian framework, according to a Calvo sticky price-setting mechanism (Çebi, 2011). Monetary and ﬁscal agents’ reactions follow conventional Taylor-type rules. The behavior of individual agents is guided by dynamic optimality and market clearing conditions. The linearized DSGE model for Egypt is composed of seven equations (depicted in Appendix). The ﬁrst equation deﬁnes an intertemporal IS (demand) curve derived from a representative individual household optimization problem that describes output as a function of real interest rate. The IS equation relates the evolution of domestic output to its expected value, technology growth, real interest rate, future realizations of changes in terms of trade and government spending and world output. On the supply side, ﬁrms set prices optimally; and their price-setting behavior is derived from maximization of future discounted proﬁts assuming staggered pricing à la Calvo. The ﬁrm’s optimal price strategy is approximated by a forward-looking open economy New Keynesian Phillips Curve describing the dynamic evolution of inﬂation in terms of current and expected inﬂation, marginal cost, current and future terms of trade and a cost push shock. Monetary policy is simulated using a Taylor rule that assumes CBE (monetary authority) Optimal rules adjusts its policy instrument in response to inﬂation, output, exchange rate and a stochastic shock. The Taylor rule accommodates inertial (interest rate smoothing) effects. A nominal exchange rate equation illustrates domestic competitiveness against the rest of the world. It relates inﬂation, nominal exchange rate change, terms of trade and world inﬂation shocks. The ﬁscal block is deﬁned by two Taylor-type functions: government spending and taxes that also allow for ﬁscal smoothing. The reaction functions permit the ﬁscal authority to adjust its spending and tax policies in response to (past) output and nominal debt stock. Fiscal policy decisions are inﬂuenced by government spending and tax shocks. Apart from their policy relevance, the ﬁscal Taylor rules offer a straightforward way to examine the cyclicality of ﬁscal policy. For instance, an expansionary ﬁscal policy stimulates the economy via increasing government spending and/or tax cuts. Hence, a positive relation between past output and government spending implies pro-cyclical ﬁscal policy. In contrast, a positive relation between past output and income tax indicates a counter-cyclical policy. Analogously, a positive output coefﬁcient in the monetary equation implies counter-cyclical monetary policy responses (Takáts, 2010). The ﬁscal block is complemented by a government solvency constraint expressed in terms of a nominal debt stock equation. The debt equation is represented by a government budget constraint where the future debt stock is a function of real debt stock, deviation between taxes and output and government deﬁcit weighted by the ratio of steady state consumption to debt as shares of GDP (Muscatelli and Tirelli, 2005 and Çebi, 2011). The model includes seven endogenous variables (output, inﬂation, nominal interest and exchange rates, ﬁscal spending and taxes and nominal budget deﬁcit) each corresponding to one of the seven equations described above. The model is closed with four additional AR(1) (autoregressive) equations describing the stochastic evolution of terms of trade changes, world output, world inﬂation and technology. Each AR equation includes an exogenous stochastic shock. Thus, the model is driven by three policy (interest rate, government spending and tax) and four exogenous shocks (Appendix). 4. Model estimation 4.1 Data description The estimation horizon spans the period from FY2004/2005:Q1 to FY2015/2016:Q4. The initial sample period promptly precedes CBE launching a corridor system to control monetary policy and adopting the overnight interbank rate as a new operational target [CBE (Central Bank of Egypt), 2010][3]. The DSGE model is calibrated using quarterly data on seven observable variables: real GDP growth, domestic CPI inﬂation, nominal exchange rate growth, terms of trade growth, interbank overnight policy rate, government spending and income taxes as shares of GDP. With the exception of terms of trade, the exogenous variables in the model are non-observable (latent). The output (real GDP) and inﬂation series are the annualized quarterly percentage real GDP and CPI growth rates, respectively. The monetary policy instrument is represented by the annualized quarterly overnight interbank interest rate. The model includes two ﬁscal instruments: nominal government spending and income tax shares to nominal GDP. Owing to deﬁciency of Egyptian import and export price statistics, the study proxies changes in foreign terms of trade by ﬂuctuations in the real exchange rate (with reference to the USD). Government expenditure and GDP at constant prices are obtained from the Ministry of Planning, Monitoring and Administrative Reform [Ministry of Planning, Monitoring and Administrative Reform (MOP), 2017]. Nominal exchange rate and CPI indexes for Egypt and the USA are retrieved from the IMF-IFS [IMF (International Monetary Fund), 2017]. Quarterly overnight interbank rate and individual income tax data are acquired from the REPS CBE (Central Bank of Egypt) (2017a). All the observable series are tested and corrected for 4,2 seasonality and demeaned prior to estimation. 4.2 Prior selection The paper implements Bayesian estimation techniques, which require choice of appropriate priors and speciﬁcation of probability distributions for the estimated parameters. Rather than adopting priors from other countries, the prior selection scheme in this paper mainly considers the realities of the Egyptian economy construed from information rooted in historical pre-sample data and previous studies for Egypt and from economic theory. The distribution density, its domain and the ﬁrst (mean) and second (standard deviation, SD) moments for the priors of the parameters are portrayed in Table I[4]. The Taylor policy rule coefﬁcients for inﬂation, output and exchange rate (c , c and 1 2 c , respectively) follow a Gamma distribution with prior mean 1.75 for c and 0.40 for c 3 1 2 and c . The inﬂation coefﬁcient prior is on the high side (in comparison with the value 1.5 commonly associated with the Taylor rule) based on earlier ﬁndings for Egypt that underscore CBE’s inclination towards an assertive (quasi-)inﬂation targeting regime[5]. The policy priors for output and exchange rate imply weaker reactions in contrast with the inﬂation coefﬁcient (Taylor, 1999 and Moursi and El Mossallamy, 2010). To avoid arbitrarily inﬂuencing the interest rate smoothing parameter estimate with tenuous opinion, the prior mean for r is set at 0.5 and is permitted to vary widely, thus allowing the data to freely determine the estimate (Fragetta and Kirsanova, 2010 and Çebi, 2011). Coef. ter. Description Density Range Mean SD s Inv. intertemporal substitution elasticity in cons. Normal (-1,þ1) 3.00 1.50 a Trade openness Beta [0,1] 0.33 0.05 w Inv. labor supply elasticity wrt real wage Normal (-1,þ1) 2.00 1.00 C Taylor rule inﬂation coefﬁcient Gamma [0, þ1) 1.75 0.75 C Taylor rule output coefﬁcient Gamma [0, þ1) 0.40 0.20 C Taylor rule exchange rate coefﬁcient Gamma [0, þ1) 0.40 0.20 u Degree of price stickiness Beta [0,1] 0.50 0.25 r Interest rate smoothing coefﬁcient Beta [0,1] 0.50 0.20 r Technology growth smoothing coefﬁcient Beta [0,1] 0.80 0.10 r Terms of trade smoothing coefﬁcient Beta [0,1] 0.50 0.10 r Government spending smoothing coefﬁcient Beta [0,1] 0.50 0.15 r Tax smoothing coefﬁcient Beta [0,1] 0.50 0.15 r World inﬂation smoothing coefﬁcient Beta [0,1] 0.50 0.10 p* r World output smoothing coefﬁcient Beta [0,1] 0.80 0.06 y* g Gov. spending coefﬁcient on past output Normal (-1,þ1) 0.3 0.05 t Tax coefﬁcient on past output Normal (-1,þ1) 0.3 0.05 g Gov. spending coefﬁcient on debt stock Normal (-1,þ1) 0.3 0.05 t Tax coefﬁcient on debt stock Normal (-1,þ1) 0.3 0.05 s SD of interest rate shock InvGamma [0, þ1) 0.40 4.00 s SD of technology shock InvGamma [0, þ1) 1.00 4.00 s SD of terms of trade shock InvGamma [0, þ1) 1.88 0.49 s SD of gov. spending shock InvGamma [0, þ1) 2.00 4.00 s SD of tax shock InvGamma [0, þ1) 1.00 4.00 s SD of world inﬂation shock InvGamma [0, þ1) 0.60 4.00 p* Table I. s SD of world output shock InvGamma [0, þ1) 5.00 4.00 y* Prior distributions s SD of mark-up shock InvGamma [0, þ1) 4.00 4.00 p The prior mean of the trade openness parameter (a) is centered around 1/3, conforming to Optimal rules the average share of total Egyptian imports in GDP during the pre-sample period 1980- 2001. The standard deviation of a is tightly set at 0.05 reﬂecting conﬁdence in the prior value. The structural parameters s and w are purportedly distributed normally, with ﬁrst and second moments centered around (3.0, 1.5) and (2.0, 1.0), respectively (Çebi, 2011). Firms in developing countries typically tend to adjust price and wage expectations more frequently – in comparison with developed countries – wing to relatively high levels of inﬂation (Almeida, 2009). This study stipulates that Egyptian ﬁrms adjust prices and wages more frequently than annually. It is assumed that the average duration of ﬁxed price contracts is half a year. Hence, the ﬁrst moment of the degree of price stickiness (Calvo) parameter is set equal 0.5 with a standard deviation of 0.25, implying a loose prior. Analogous to the monetary smoothing coefﬁcient, the prior means for r and r in the g t ﬁscal Taylor rules are set at the middle of the interval [0,1]. The literature suggests that ﬁscal feedback is usually small (Kirsanova and Wren-Lewis, 2011). In absence of a priori knowledge about the (absolute) size of the ﬁscal coefﬁcients on lagged output and debt, a small value (0.3) with standard deviation of 0.05 is chosen for all four coefﬁcients g , t , g b b y and t . The sign of the debt stock parameters t and g are determined according to y b b expectations about ﬁscal authority commitment to debt stabilization. It is anticipated that an increase in debt stock would be accompanied by a contractionary ﬁscal policy involving reduction in government spending and/or increase in taxes (Çebi, 2011). Moreover, the signs of the output coefﬁcients in the ﬁscal rules (Table I) imply pro-cyclic government spending policy (i.e. increasing government expenditures is expansionary) and counter-cyclical income tax policy (i.e. positive tax shock is contractionary). The autoregressive parameters priors for r and r are set conservatively at the middle q p* of the interval [0,1] while prior means for technology growth and world output (r and r , A y* respectively) that typically exhibit persistence are set equal 0.8[6]. Again standard deviations for those parameters accommodate loose priors. Three parameters in the model are calibrated. The ratio of private consumption to gross domestic debt (C=B)is ﬁxed at its average value (0.82) during the pre-sample period 2001/ 02-2003/04 [CBE (Central Bank of Egypt), 2017a]. The discount factor (0.99) is parametrized based on an estimate of the steady state real interest rate for Egypt (approximately 4 per cent) during 2001-2006 (Moursi et al., 2007). The elasticity of substitution between domestic and foreign goods is ﬁxed at unity (Fragetta and Kirsanova, 2010). The ﬁrst and second moment priors for the standard deviation of all the exogenous shocks in the model are chosen in line with comparable studies for Egypt (Moursi and El Mossallamy, 2010). The second moments are selected to ensure that the priors are in general sufﬁciently not informative (Table I). 4.3 Estimation results Bayesian methods have become increasingly popular in estimation of DSGE models. Their advantage over classical methods mainly resides in their ability to synergize both data based (likelihood function) and non-data based information included in the prior distributions of parameters (Fernández-Villaverde and Rubio-Ramirez, 2001 and Smets and Wouters, 2003). The DSGE system of equations for Egypt is solved using conventional state-space and Bayesian methods. The likelihood function and the priors are ﬁrstly combined to obtain the posterior distributions for the structural parameters. The Kalman ﬁlter technique is used to provide inferences about non-observable variables and to numerically evaluate the likelihood function and the posterior mode conditional on the estimated parameters. Bayesian estimation is then implemented by summarizing the information included in the likelihood REPS function through allocating prior distributions to the estimated parameters. The Metropolis- 4,2 Hastings (M-H) algorithm is utilized to draw a sequence based on 500,000 Monte Carlo Markov Chain samples with two distinct parallel chains from the posterior distribution of the model and to evaluate the numerical maximization of the posterior distribution. Upon convergence of the algorithm, the Markov chain draws are used, after discarding the initial 50 per cent iterations as burn in, to estimate the posterior distribution moments of the model parameters (Juillard, 2014 and Griffoli, 2013). Table II portrays the Bayesian estimates of the DSGE model. Together with the posterior mean point estimates, the table reports a 90 per cent conﬁdence intervals and the acceptation rates for each Markov Chain. The acceptation rates – virtually equal the ideal 25 per cent – establish the viability of the M-H algorithm solution and conﬁrm that the solver did not run into difﬁculties during application (Griffoli, 2013). Table II shows that the estimated posterior means of the policy parameters are signiﬁcantly different from prior values, thereby substantiating that they draw on important information from the data[7]. The inﬂation response c exceeds one in accord with the Taylor principle required to ensure model stability (Vieira et al., 2016)[8]. The large estimate of c (>3.0) implies that the monetary authority pursues an aggressive anti- inﬂation policy to achieve its primary objective of maintaining price stability [CBE (Central Bank of Egypt), 2017b]. 90% Confidence interval Prior mean Posterior mean LB UB Prior SD u 0.50 0.11 0.00 0.23 0.25 C 2.00 2.17 1.30 3.01 1.00 s 3.00 2.73 1.62 3.73 1.50 r 0.50 0.84 0.75 0.93 0.20 C 1.75 3.01 1.86 4.16 0.75 C 0.40 0.95 0.40 1.49 0.20 C 0.40 0.07 0.01 0.12 0.20 r 0.50 0.82 0.72 0.93 0.15 g 0.30 0.29 0.21 0.37 0.05 r 0.30 0.26 0.17 0.35 0.05 g 0.30 0.29 0.38 0.21 0.05 t 0.30 0.26 0.17 0.34 0.05 r 0.50 0.84 0.74 0.95 0.15 r 0.80 0.78 0.67 0.89 0.10 r 0.80 0.94 0.90 0.98 0.06 y* r 0.50 0.18 0.10 0.26 0.10 r 0.50 0.37 0.24 0.49 0.10 p* a 0.33 0.33 0.24 0.42 0.05 s 4.00 2.77 1.09 4.57 4.00 s 1.00 0.37 0.25 0.47 4.00 s 0.60 3.93 3.24 4.62 4.00 p* s 5.00 4.15 1.70 6.97 4.00 y* s 0.40 0.20 0.11 0.29 4.00 s 2.00 0.55 0.45 0.63 4.00 s 1.00 0.14 0.12 0.15 4.00 Table II. s 1.88 2.53 2.13 2.91 0.49 Estimation results Acceptance (%) 25.33; 25.04 With an estimated value of c = 0.95, CBE apparently attaches substantial importance to 2 Optimal rules output targeting. In contrast, the response of CBE to exchange rate variance is not quite as intense. The posterior mean for c reveals that the CBE responds to a nominal depreciation with a monetary tightening equal 7 per cent of the initial percentage-point exchange rate. Moreover, interest rate smoothing considerably inﬂuences CBE policy decisions (r = 0.84)[9]. The estimates of the policy parameters are qualitatively consistent with empirical DSGE literature. According to Lubik and Schorfheide (2007),the inﬂation response parameter c typically falls between 1.84-2.49 while c and c range from 0.15-0.29 and 0.07-0.24, 2 3 respectively. Except for a higher output response[10], the estimates seem in line with previous ﬁndings characterizing monetary policy in Egypt (Moursi and El Mossallamy, 2010). All the ﬁscal policy parameters are statistically signiﬁcant (Table II). The large values of the lagged ﬁscal coefﬁcients for government spending and taxes (r = 0.82 and r 5 0.84) g t emphasize the inﬂuential role of policy smoothing in the evolution of ﬁscal strategies in Egypt. As g > 0, government spending is pro-cyclical (increases during booms and falls in recessions). Such pro-cyclicality is a common feature in developing countries, which is frequently attributed to credit supply problems that occur in periods of economic downturn (Kaminski et al., 2004). Moreover, pro-cyclic government spending could be intensiﬁed when a bulk of the government budget is composed of ﬁxed expenses that the ﬁscal agent cannot directly adjust in the short-run e.g. wage bill and interest payments in the case of Egypt (Panizza, 2001). The positive correlation between (past) output and income tax (t > 0) denotes a counter- cyclical ﬁscal policy. As tax revenues are under the ﬁscal authority’s control, the government has the ﬂexibility to interfere by cutting (raising) taxes during recessions (booms) to stabilize the economy by stimulating the economic activity during a downturn period and restraining it during an upturn. Table II portrays the posterior mean estimates for the feedback coefﬁcients of debt stock in the government spending (0.29) and income tax (0.26) rules. The signiﬁcance of both estimates conﬁrms the importance of the debt stabilization motive in the conduct of ﬁscal policy. The positive sign of t shows that a rise in debt stock induces the ﬁscal agent to raise taxes to stabilize debt. Alternatively, g < 0 implies that an increase in debt is accompanied by contractionary ﬁscal policy that reduces government expenditure. Accordingly, the ﬁscal authority in Egypt seems to embrace a passive policy in the Leeper (1991) sense. This means that the ﬁscal authority is required to generate sufﬁcient revenues – by adjusting taxes and/ or government spending – to balance the budget deﬁcit while restricted by the monetary authority behavior. Thus, the ﬁscal decision rule is a function of current public debt position. Finally, the trade openness estimate (a = 0.33) exceeds the actual share of Egyptian imports in GDP (27 per cent). A higher level of openness may reﬂect stronger effects of nominal exchange rate on prices. As exchange rate movements affect domestic inﬂation through import price changes, higher trade openness implies stronger exchange rate pass- through effects on inﬂation as the economy becomes more vulnerable to international price shocks. Though statistically identiﬁed, the relation between the prior and the posterior estimate of a reveals that openness may not be driven by the data, especially, that the estimated posterior mean is close to its prior value, thereby supporting that it does not draw on important information from the data. The Calvo parameter (u ) implies that the average length of contracts is kept constant for a tad over one quarter. Hence, ﬁrms resort to adjust prices frequently owing to economic volatility (Smets and Wouters, 2003). 4.4 Posterior transmission dynamics REPS Bayesian impulse response functions (IRFs) are displayed in a graphical matrix (Figure 1). 4,2 The IRFs describe the dynamic effects of stochastic shocks on endogenous variables in the model at the posterior mean of the parameter estimates. Figure 1 depicts the mean response (solid line) of the endogenous variables ﬂanked by 90 per cent upper and lower conﬁdence intervals (dotted lines). In each plot, the y-axis expresses deviations from the steady state owing to a shock and the x-axis represents a time horizon spanning 40 quarters. That horizon is sufﬁcient for all variables to return to steady-state values following a shock, thus providing further validation for stability of the model solution. The ﬁrst row in Figure 1 depicts the effects of a positive monetary shock on endogenous variables. The tight conﬁdence bands assert statistical signiﬁcance of the estimated responses. As expected, a contractionary monetary shock reduces both output and inﬂation. Higher interest rate increases the cost of debt services, which raises real government debt. Accumulation of debt stock induces the ﬁscal authority to implement a tight stabilization policy (i.e. increase income tax and reduce government spending) to offset the increase in debt. These responses are naturally consistent with the posterior point estimates of the ﬁscal Taylor rules (Table II). Furthermore, except for inﬂation, responses of the selected variables require a relatively extended period to dissipate, implying a sizable degree of persistence in the monetary policy shock transmission mechanism. An increase in government spending normatively induces a rightward shift in the IS curve driving up nominal interest rate, output and prices. Figure 1 shows that the increase in output and interest rate arising from a positive government spending shock dissipates within almost eight quarters. The increase in inﬂation upon impact seems statistically insigniﬁcant. This limited effect on inﬂation may result from the opposing effect of higher interest rates on prices. Fiscal expansion increases government deﬁcit owing to the positive response of ﬁscal debt to a government spending shock. The effect is further magniﬁed by the impact of increasing debt interest payments caused by the rise in the level of nominal interest rate. To ﬁnance debt service payments, the ﬁscal authority responds by raising taxes. The effects on debt and taxes persist for some time after the shock. Monetary Shock Monetary Shock Monetary Shock Monetary Shock Monetary Shock Monetary Shock –3 0 20 0 0.4 0.02 –0.1 –0.01 0.3 0.015 –0.01 –0.2 10 0.2 –0.02 0.01 –0.3 0.1 0.005 –0.02 –0.03 0 0 –0.4 0 8 16 24 32 40 816 24 32 40 816 24 32 40 816 24 32 40 0 8 16 24 32 40 0 8 16 24 32 40 Tax Shock Tax Shock Tax Shock Tax Shock Tax Shock Tax Shock –3 –3 10 10 0.15 5 0.04 0 0 0.01 0 0.1 0.03 –0.2 –5 –5 0.02 0.05 –0.4 –10 0.01 –10 –0.01 –15 –0.6 0 8 16 24 32 40 816 24 32 40 8 16243240 8 16243240 0 8 16 24 32 40 0 8 16 24 32 40 Gov. Spending Shock Gov. Spending Shock Gov. Spending Shock Gov. Spending Shock Gov. Spending Shock Gov. Spending Shock 0.15 0.6 0.08 0.1 0.2 0.06 0.1 0.4 0.04 0.1 1 0.2 0.05 Figure 1. 0.02 0 0 IRF to policy shocks –0.1 0 8 16 24 32 40 816 24 32 40 816 24 32 40 816 24 32 40 0 8 16 24 32 40 0 8 16 24 32 40 Output Output Output Inflation Inflation Inflation Interest Rate Interest Rate Interest Rate Tax Tax Tax Gov. Spending Gov. Spending Gov. Spending Gov. Debt Gov. Debt Gov. Debt Tight ﬁscal policy (a positive tax shock) considerably curbs government debt through Optimal rules raising tax revenues, which promote increases in government spending. For the ﬁrst year and half or so (six quarters), the positive income tax shock entails counter-cyclical policy exhibiting contractionary effects. The counter-cyclicality is reversed as the increase in government spending associated with higher ﬁscal revenues dynamically outweighs the negative tax effects and propels growth (Figure 1). The diagram also illustrates that a tax shock has no statistically signiﬁcant effect on monetary policy and consequently does not affect domestic inﬂation. So far the paper has focused on analyzing the behavior of monetary and ﬁscal policies using Taylor instrument rules. In the following section, policy reaction functions are reformulated within an OSR optimization setting. 5. Optimal monetary and ﬁscal policy analysis Several papers including Bache et al. (2010) study the conduct of monetary policy within a general equilibrium framework under two alternative modeling formulations. The ﬁrst formulation examines monetary policy reaction functions with simple instrument rules; the second (OSR) focuses on gauging monetary policy objectives by optimizing an intertemporal loss function to derive an optimal policy rule. Bache et al. (2010) contrast estimates derived from each of those formulations using a DSGE model for Norway. They ﬁnd that the two monetary policy speciﬁcations lead to similar policy responses. The following results show this is not the case for Egypt. 5.1 Bayesian optimal simple rule estimation It is stipulated that monetary and ﬁscal authorities are committed to an OSR by minimizing a weighted intertemporal quadratic loss function, which quantiﬁes welfare losses that occur when the volatility of the selected target variables increases. The speciﬁcation of the loss function, therefore, varies depending on the chosen target variables and on weights assigned to each of those variables (Adjemian et al., 2014). In this study, the loss function comprises both monetary and ﬁscal policy targets. The monetary authority is presumed to minimize the weighted average of the variances of three target variables: inﬂation, output and exchange rate. The loss function introduces a penalty on excessive ﬂuctuations in the overnight policy rate. Moreover, ﬁscal authority targets debt and output stabilization while controlling for extreme government spending and income tax movements. The choice of elements of the weighting matrix multiplied by the set of target variables entering the OSR maximand is a function of the preferences that characterize different policy strategies of the monetary and ﬁscal agents. The study proposes three (hypothetical) combinations of weights for the OSR simulations corresponding to different preference mixes of monetary and ﬁscal agents. Table III depicts the target variables weights for the three scenarios. The ﬁrst (Scenario I) assigns equal weights for monetary and ﬁscal policy targets, allowing central bank to consider inﬂation and other target variables. In this case, the monetary authority is said to be committed to ﬂexible rather than strict inﬂation targeting (Svensson, 1997). With ﬂexible inﬂation targeting, it would be possible to maintain moderate levels of exchange rate volatility, thus permitting analysis of the impact of monetary policies directed at stimulating economic growth via enhancing investment incentives. Scenario II (III) suggests moderately high (low) weights for monetary relative to ﬁscal targets in comparison with Scenario I. The OSR problem involves minimizing a loss function consisting of the weighted sum of (unconditional) ﬁnite variances of the deviation of the selected target variables from the steady state subject to a linear law of motion derived from the ﬁrst order approximation of the equilibrium conditions represented by the DSGE model (Adjemian et al., 2014 and Vieira REPS et al., 2016)[11]. A subset of the DSGE model parameters, namely the monetary and ﬁscal 4,2 policy coefﬁcients, is selected for optimization. The OSR computation is performed via a numerical optimization algorithm[12]. The optimal policy parameters and corresponding loss function estimates for each scenario are reported in Table IV. The OSR estimates conﬁrm that the inﬂation coefﬁcients satisfy the Taylor principle (C > 1). Because the estimates of C range from 1.42 to 2.08, 1 1 the scenarios generally suggest that it is better for the monetary authority to moderately target inﬂation. The magnitude of the inﬂation coefﬁcient depends on policy preferences. Assigning relatively bigger weights for monetary compared to ﬁscal targets (Scenario II) gives higher priority to inﬂation targeting (C = 2.08). However, all the OSR estimates ofC 1 1 are fairly lower than the posterior inﬂation coefﬁcient derived from the Taylor rule (3.01). In contrast with a rather high output coefﬁcient estimate in the Taylor rule (C = 0.95), the OSR discloses an almost muted response to output in the three scenarios: monetary authority will not signiﬁcantly respond to output ﬂuctuations when formulating an optimal policy (Table IV). A possible reason for the subdued OSR output feedback response is that successful inﬂation stabilization by the monetary authority may itself lead to output stabilization. Hence, CBE does not account for output ﬂuctuations when optimally setting the operational target (Vieira et al., 2016)[13]. The OSR scenarios reveal that the monetary authority could be better off if it were to target exchange rate variations. As shown in Table IV, the OSR exchange rate coefﬁcients Policy scenarios Weights Scenario I Scenario II Scenario III v 1.0 1.0 0.5 v 1.0 1.0 0.5 v 1.0 1.0 0.5 Table III. v 1.0 1.0 0.5 Preferences weights v 1.0 0.5 1.0 for monetary and v 1.0 0.5 1.0 ﬁscal targets v 1.0 0.5 1.0 Posterior mean* Scenario I Scenario II Scenario III C 3.01 1.53 2.08 1.42 -05 -04 -05 C 0.95 8.24 10 2.04 10 1.89 10 C 0.07 0.55 1.05 0.34 t 0.26 0.20 0.39 0.14 t 0.26 3.17 1.78 4.23 g 0.29 0.37 1.14 0.08 g 0.29 1.18 0.46 5.61 r 0.84 0.42 0.53 0.39 r 0.82 0.22 0.47 0.08 Table IV. r 0.84 0.01 0.01 0.01 Policy parameters Loss Function 37.32 35.16 20.16 and loss functions for OSR scenarios Note: *DSGE simple Taylor rule point estimates (see Table 2) (C ) are markedly larger – ranging from 0.34 to 1.05 – compared with the analogous Taylor 3 Optimal rules rule estimate (0.07). Scenario II reﬂects the biggest exchange rate response (1.05) because of relatively bigger monetary policy weights. The OSR estimates show that the ﬁscal authority heavily targets debt stabilization. Table IV illustrates that optimal values of t range from 1.78 to 4.23, while optimal g levels fall between 0.46 and 5.61. Despite considerably larger reactions implied by the OSR parameters vis-à-vis ﬁscal Taylor rule estimates, the direction of corresponding OSR and Taylor rule responses remains the same, i.e. government spending (income tax) response is negatively (positively) associated with positive debt shocks. Assigning bigger weights for income tax (relative to monetary) targets accentuates the ﬁscal authority tendency to adjust taxes to balance the intertemporal government budget. Hence, according to the OSR scenarios, optimal Egyptian ﬁscal behavior is consistent with a Leeper (1991) passive policy. In case of an increase in ﬁscal debt, a passive Leeper monetary stance would support the consolidation of the ﬁscal balance and promote economic growth, accompanied though with higher inﬂationary pressure. Alternatively, if CBE were to adopt an active policy, then the ﬁscal debt stabilization policy may get restrained by the discretionary effects of monetary policy. Hence, in view of what is mentioned above concerning active monetary policy, prevailing public debt would not preclude CBE in adjusting its policy instrument to gain price stability. Alternatively, the passive ﬁscal authority is dominated by the monetary authority behavior and is obliged to ﬁnance the government budget deﬁcit. The OSR ﬁndings reveal that the ﬁscal authority moderately targets output stabilization, especially when assigning relatively higher weights to output variability in the objective function (Scenario II). Table IV shows that the optimal income tax response to output (0.39) in Scenario II exceeds the analogous posterior mean (0.26) estimated under the Taylor rule equation. This pattern is more pronounced when government spending is used as a ﬁscal instrument. The pro-cyclicality of government spending is a common feature in many developing countries adopting a ﬁscal Taylor rule (Gavin and Perotti, 1997). The optimal ﬁscal rule estimates reported in Table IV provide supporting evidence. The positive estimates of g suggest that optimized government spending in Egypt is pro- cyclic, increasing during a boom and falling in periods of recession. Kaminski et al. (2004) attribute pro-cyclicality of ﬁscal policy in developing countries to credit constraints that arise during bad times. In periods of recession, instead of stabilizing the economy by promoting economic activity through ﬁscal stimulus, countries cut government expenditure as they confront difﬁculties in borrowing, especially if they suffer from high interest payments and accumulated budget deﬁcit. Lack of international ﬁnancing during periods of downturns may lead to a rise in interest rate owing to the increase in the risk premium of the country. Analogous to previous results, pro-cyclicality of government expenditure in Egypt is captured by the OSR. The substantial share of ﬁxed expenses in total expenditure limits government capacity to implement an optimal independent ﬁscal policy, as these expenses represent outcomes of earlier decisions that are not easily adjustable without prompting economic imbalances (Gavin et al., 1996). The average wage bill and interest payments in Egypt hovered around 25 and 28 per cent, respectively, during the period 2014/15-2016/17. The OSR estimates demonstrate counter-cyclicality of income taxes, t > 0(Table IV). As tax revenues are under the ﬁscal authority’s control, optimal ﬁscal strategies recommend that government interfere by collecting higher taxes during booms and cutting taxes during REPS recessions to maintain stability and lessen adverse effects on budget deﬁcit during economic 4,2 downturns. Finally, the Taylor rule results imply that both monetary and ﬁscal decisions are excessively transparent to the extent that may limit their effect on strategic policy outcomes if rational economic agents build predictable future policies into the decision mechanisms. The OSR scenarios emphasize that monetary and ﬁscal agents should depend less on policy smoothing. Table IV shows that the optimal smoothing parameters (r , r and r ) – ranging from 0.39 to 0.53 – are much less than the R g t analogous estimates obtained from the monetary and Taylor-type ﬁscal rules (0.82-0.84), suggesting that the OSR supports immediate substantial responses to shocks. 6. Conclusion The paper uses a New Keynesian DSGE model for the Egyptian economy to assess the interactions and contribution of monetary and ﬁscal policies to economic stabilization. The study uses Taylor-type rules and an OSR to explore the economic outcomes of monetary and ﬁscal authority commitment to different policy instruments. The DSGE model is calibratedusing quarterlydatafor theperiod FY2004/2005:Q1-FY2015/2016:Q4 and the structural policy parameters are estimated using Bayesian techniques. The results show that monetary and ﬁscal policy instruments (interest rate and government spending and taxes, respectively) in Egypt contribute to economic stability through their effects on inﬂation, output and debt stock. The monetary policy Taylor rule estimates reveal that CBE attaches signiﬁcant importance to anti-inﬂationary policy and (to a lesser extent) to output targeting but responds weakly to nominal exchange rate variations. CBE decisions are signiﬁcantly inﬂuenced by interest rate smoothing, which render its policy overtly transparent and anticipated i.e. insufﬁciently effective. Egyptian ﬁscal policy has an important role in output and government debt stabilization. The results show that the ﬁscal authority opts for debt stabilization according to a Leeper (1991) passive policy. This means that the ﬁscal authority adjusts its policy instruments in response to public debt (i.e. it increases taxes and/or reduces government expenditures to counterbalance budget deﬁcit). Additionally, the ﬁscal authority chooses pro-cyclical government spending and counter-cyclical tax policies for output stabilization. Again past values of the ﬁscal instruments are inﬂuential in the evolution of the future ﬁscal policy- making process. Optimal policy parameter estimates based on an OSR suggest it would be better if CBE moderately responds to inﬂation and targets exchange rate variations. However, monetary authority will not accommodate output ﬂuctuations when optimally setting its operational target. Furthermore, the OSR supports adopting a Leeper (1991) passive ﬁscal stance that (in contrast with monetary policy) moderately targets output stabilization. In the OSR optimization mode, government spending in Egypt exhibits a pro-cyclical pattern that could be attributed to the substantial share of ﬁxed expenses in total expenditure, which limit the ability of the government to implement ﬁscal policy adjustments that are independent of past decisions without prompting economic imbalances. As tax revenues are readily under the ﬁscal authority control, optimal government policy should consider implementing a counter-cyclical tax policy to stabilize the economy and reduce ﬁscal budget pressures during economic downturns. Finally, the OSR scenarios emphasize that the Optimal rules monetary and ﬁscal agents should limit dependence on policy smoothing. Notes 1. According to Leeper (1991), a policy is active/passive conditional on its reaction to public debt shocks. 2. CBE has announced its commitment to 13% (63%) inﬂation target (CBE, 2018). 3. The corridor system was introduced in June 2005 to manage monetary policy by imposing a ceiling and a ﬂoor on the overnight rate in order to control inﬂationary pressure (CBE, 2010). 4. The choice of prior densities imposes size restrictions on the ﬁrst moment of the parameters. Gamma and inverse Gamma distributions restrict the mean to be positive, Beta distribution restricts it to fall between zero and one and normal distribution allows for a non-bounded mean (Almeida, 2009). 5. The complete set of requirements for inﬂation targeting have not yet been installed in Egypt. 6. See Moursi and El Mossallamy (2010) for Egypt and Lubik and Schorfheide (2007) for international evidence. 7. Formal tests (not reported) show that all the parameter estimates are statistically identiﬁed, indicating that the model ﬁts the observed data well. 8. The Taylor principle states that one percentage point increase in inﬂation leads the monetary authority to raise nominal interest rate by more than one percentage point, which guarantees that the real interest rate increases when inﬂation rises (Taylor, 1999). Since a rise in real interest rate reduces output and leads to lower inﬂation, the Taylor principle ensures economic stability by precluding inﬂationary spirals. 9. Empirical evidence suggests that the interest rate smoothing parameter typically ranges from 0.7-0.9 (Lubik and Schorfheide, 2007). 10. Moursi and El Mossallamy (2010) ﬁnd smaller output response (0.21) in Egypt during the period 2002-2008, suggesting less concern about output in comparison with inﬂation targeting. 11. Stationarity of the endogenous variables ensures that variances are ﬁnite. 12. The Matlab toolbox Dynare (Adjemian et al., 2014) is used to solve the OSR numerical optimization problem. 13. 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(1999), “The robustness and efﬁciency of monetary policy rules as guidelines for interest rate setting by the European Central bank”, Journal of Monetary Economics, Vol. 43 No. 3. Svensson, L. (1997), “Inﬂation targeting in an open economy: strict or ﬂexible inﬂation targeting?”, Reserve Bank of New Zealand Discussion Paper, Series G97/8. Vieira, P., Machado, C. and Ribeiro, A. (2016), “Optimal ﬁscal simple rules for small and large countries of a monetary union”, EcoMod2016 [9685], available at: https://ideas.repec.org/p/ekd/009007/ 9685.html World Bank (2015), Egypt, Arab Republic of – Country Partnership Framework for the Period FY2015-19 (English), World Bank Group, Washington, DC, available at: http://documents.worldbank.org/ curated/en/773051468197407822/Egypt-Arab-Republic-of-Country-partnership-framework-for-the- period-FY2015-19 Appendix The DSGE model equations are presented below. Description of parameters not deﬁned in this Appendix is listed in Table I: 1. IS curve 1 ðÞ 1 þ w a y ¼ E y E Dg ðÞ R E p ðÞ 1 r A E Dq t t tþ1 t tþ1 t t tþ1 t t tþ1 s s þ w s a a a ðÞ aw v 1 1 r y y* s þ w (1) s ðÞ where s ¼ and v ¼ sh þ 1 aðÞ sh 1 , h is the elasticity of substitution REPS 1aðÞ 2aðÞ 1sh between domestic and foreign goods, D is the ﬁrst difference operator, output 4,2 y ¼ ln Y =Y ¼ y y (y is the steady state value of y ), g is government spending, R is t t t t t t nominal interest rate, p is domestic inﬂation, q denotes terms of trade and y and A represent t t t world output and technology processes, respectively (Lubik and Schorfheide, 2007). 2. New Keynesian Phillips Curve p ¼ b E p þ ab E Dq aDq þ l d s þ wðÞ y y s g þ t eþ e ðÞ t t tþ1 t tþ1 t a t t a t t (2) ðÞ 1þw ðss Þ a * where y is potential output: y5 A y , l is the slope of the New Keynesian Phillips t t t s þw s þw t ðÞ a ðÞ a ðÞ ðÞ 1 bu 1 u curve: l ¼ , marginal cost =ðÞ s þ wðÞ y y s g þ t , t denotes income taxes a t t a t t t and e is a cost-push shock. 3. Monetary policy Taylor rule n n R R ¼ r R R þðÞ 1 rðÞ W p þ WðÞ y y þ W Deþ R þ e (3) t t1 1 t 2 t t 3 t R t1 R t t ðÞ 1 þ w s ðÞ n n a aw v1 * R R is natural interest rate: R ¼ r 1 A þ r 1 y and e is a monetary ðÞ * t t s þ w a s þ w y t t a a policy shock (Çebi, 2011). 4. Exchange rate equation ðÞ p ¼ De þ 1 a Dq þ p (4) t t t where e is nominal exchange rate and p is a world inﬂation shock. Fiscal Taylor-type rules 5. Government spending g ¼ r g þ 1 r dg y y þ g b eþ e (5) ðÞ t t1 y t1 t1 b t g g t 6. Taxes t ¼ r t þ 1 r dt y y þ t b eþ e (6) ðÞ ðÞ t t1 y t1 b t t t t1 t where b is nominal debt stock and e and e are government spending and tax shocks, t t respectively. 7. Fiscal solvency constraint 1 C b ¼ R þ b p þðÞ 1 b t y þ g t (7) ðÞ ðÞ tþ1 t t t t t t t where C and B are steady state consumption and debt to GDP ratios, respectively. 8-11. AR(1) stochastic shocks Optimal rules Dq ¼ r Dq þ e (8) t t1 q t * * y* y ¼ r y þ e (9) t y * t1 t * * p* p ¼ r p þ e (10) p * t t1 t A ¼ r A þ e (11) t t1 A t q y* p* A where e ; e ; e and e are exogenous shocks for terms of trade, world output, world inﬂation and t t t t technology, respectively. Corresponding author Mai El Mossallamy can be contacted at: maymosalamy@yahoo.com For instructions on how to order reprints of this article, please visit our website: www.emeraldgrouppublishing.com/licensing/reprints.htm Or contact us for further details: permissions@emeraldinsight.com
Review of Economics and Political Science – Emerald Publishing
Published: Jun 19, 2019
Keywords: DSGE; Economic stabilization; Monetary and fiscal policy; Optimal rules; E52; E61; E62; E63
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